Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy- Cost of Capital © The McGraw−Hill^539
Companies, 2002
if we use the WACC to evaluate it, it will appear to be attractive. So the second error that
will arise if we use the WACC as a cutoff is that we will tend to make unprofitable in-
vestments with risks greater than those of the overall firm. As a consequence, through
time, a firm that uses its WACC to evaluate all projects will have a tendency to both ac-
cept unprofitable investments and become increasingly risky.
Divisional Cost of Capital
The same type of problem with the WACC can arise in a corporation with more than one
line of business. Imagine, for example, a corporation that has two divisions, a regulated
telephone company and an electronics manufacturing operation. The first of these (the
phone operation) has relatively low risk; the second has relatively high risk.
In this case, the firm’s overall cost of capital is really a mixture of two different costs
of capital, one for each division. If the two divisions were competing for resources, and
the firm used a single WACC as a cutoff, which division would tend to be awarded
greater funds for investment?
The answer is that the riskier division would tend to have greater returns (ignoring
the greater risk), so it would tend to be the “winner.” The less glamorous operation
might have great profit potential that would end up being ignored. Large corporations in
the United States are aware of this problem, and many work to develop separate divi-
sional costs of capital.
The Pure Play Approach
We’ve seen that using the firm’s WACC inappropriately can lead to problems. How can
we come up with the appropriate discount rates in such circumstances? Because we
cannot observe the returns on these investments, there generally is no direct way of
coming up with a beta, for example. Instead, what we must do is examine other invest-
ments outside the firm that are in the same risk class as the one we are considering and
use the market-required returns on these investments as the discount rate. In other
words, we will try to determine what the cost of capital is for such investments by try-
ing to locate some similar investments in the marketplace.
For example, going back to our telephone division, suppose we wanted to come up
with a discount rate to use for that division. What we could do is identify several other
phone companies that have publicly traded securities. We might find that a typical
phone company has a beta of .80, AA-rated debt, and a capital structure that is about 50
percent debt and 50 percent equity. Using this information, we could develop a WACC
for a typical phone company and use this as our discount rate.
Alternatively, if we were thinking of entering a new line of business, we would try to
develop the appropriate cost of capital by looking at the market-required returns on
companies already in that business. In the language of Wall Street, a company that fo-
cuses on a single line of business is called a pure play.For example, if you wanted to bet
on the price of crude oil by purchasing common stocks, you would try to identify com-
panies that dealt exclusively with this product because they would be the most affected
by changes in the price of crude oil. Such companies would be called pure plays on the
price of crude oil.
What we try to do here is to find companies that focus as exclusively as possible on
the type of project in which we are interested. Our approach, therefore, is called the pure
play approachto estimating the required return on an investment. To illustrate, suppose
McDonald’s decides to enter the personal computer and network server business with a
line of machines called McPuters. The risks involved are quite different from those in the
CHAPTER 15 Cost of Capital 511pure play approach
The use of a WACC that
is unique to a particular
project, based on
companies in similar
lines of business.